INTERNATIONAL TRADE: Re-inventing the wheel of international trade

The world's chronically-unbalanced trading system has been the trigger for the financial crash, writes Colin Teese.

After 25 years, the world seems to be giving up on the failed experiment of free market fundamentalism, although it hasn't yet totally abandoned some commitment to free trade.

Such has been the enthusiasm for this recent orthodoxy that critics of the free market experiment over the last 25 years have been either ignored or routinely ridiculed.

However, informed opinion around the world is beginning to identify a link between an unbalanced international trading system (the divergence between "spending" and "saving" economies) and the financial meltdown which, a couple of years ago, catapulted the world into what appears to be enduring slump.

But all the dots are still to be connected. There isn't yet universal recognition that "floating" currencies and an unregulated trading system have contributed to dividing the world into "spending" and "saving" economies.

But the signs are encouraging. While lip service is still being paid to the principle of free trade, G20 countries are taking measures to defend their borders against imports, coupled with spending campaigns aimed at restoring the health of domestic industries. In the present climate, maintaining domestic consumer demand and employment trumps free trade any time.

Meanwhile, the commentating cognoscenti agonise over how it all happened, and how we might climb out of it. A solution won't become clear until they begin connecting up the trade dots.

Australia's ideologues will certainly be among the last to do this. Such was their commitment to free trade orthodoxy that they actually believed - and managed to convince governments - that measures maintained by Australia to keep out tainted plant and animal imports were actually disguised trade restrictions.

They were similarly hostile towards measures - legally sanctioned under World Trade Organisation rules - to shield our farmers and manufacturers from the adverse effects of subsidised imports entering Australia at unrealistically low prices (what is technically called "dumping").

Of course, nobody should object to the world's trading nations agreeing on rules which aim to minimise trade barriers, consistent with national development aspirations - and, it might be added, common sense.

International cooperation on trade rules, as expressed in the 1944 Bretton Woods agreement which led to the establishment of the 1948 General Agreement on Tariffs and Trade (GATT), was justifiably recognised as essential to the future good economic organisation of the post-World War II world.

From the start, GATT was realistic about what could and should be done. Read the GATT rules and you won't see anything about "free trade", but a great deal about growth, international economic development and full employment.

Things didn't start to go wrong until the trading world established the World Trade Organisation (WTO) in 1995, based on tighter and binding rules. How, it might be asked, can this be linked with the recent destabilisation of the world trading system?

It all becomes understandable if we go back to the Bretton Woods settlements. At that time, the United States agreed to underwrite the trading system of the West, based on a set of rules expressed in GATT and underwritten by the International Monetary Fund (IMF).

Those countries which signed up for the GATT were not bound by GATT rules. Rather, they committed themselves to do no more than their best to follow the rules. This system worked well for the first 25 years; thereafter, it limped on for another 20 or so years.

Negotiations from 1984 onwards to establish the WTO were trumpeted as an attempt to make the GATT rules binding, more effective and more conducive to promoting free trade.

Without going into the detail of what might be wrong with the WTO as a replacement for GATT, it has to be said that in 15 years those objectives have not been achieved. Nor has the system, overall, worked better.

We can't entirely blame the WTO for the unbalancing of the global economic system. Breakdown was already occurring, even before the WTO negotiations began. But with the system already under strain, abandoning "best endeavours" obligations in favour of binding commitments was not the cleverest of ideas.

Malfunction

In fact, it is necessary to go back to the early 1970s to identify reasons why the system began to malfunction. This was indeed the time when free trade ideologues first began to have their impact upon international trade policy. Yet they would not have achieved such a position of influence, were it not for the fact that, after 1971, the US could no longer underwrite international trade in line with the commitment it undertook years before at Bretton Woods.

Until that time, the US operated a kind of gold standard, somewhat like the one that the British had maintained before 1914. After 1970, internal economic and financial problems meant that the US could no longer honour a commitment to countries holding US dollar reserves to exchange, on demand, their dollars for gold (at the fixed price of some $US35 per ounce).

The West's trading system was an immediate sufferer. First, its trading currencies could no longer be kept in a close and fairly stable value relationship with the US dollar - and, therefore, with each other.

In the inevitable uncoupling process, currency values, no longer pegged to each other and often subject to speculative raids, changed hour by hour. The buying and selling of currencies, instead of being primarily connected with facilitating international trade, now became an end in itself.

Prompted by a change in political and economic direction in the US, pressures mounted, especially in Western economies, for full financial and economic deregulation. Market fundamentalism legitimised the subsequent currency speculation which fully flexible exchange rates encouraged. Without an anchor point, such currencies could and did move up or down at will - that is, "float".

Floating currencies immediately made life more difficult for exporters. Unable to anticipate fixed currency relationships, exporters either had to bear the risk of loss on currency movements on the goods they bought and sold, or take out costly insurance against unanticipated currency movements.

Economic fundamentalists dismissed such concerns as unduly pessimistic and alarmist. They maintained that financial deregulation, floating exchange rates and the absence of a US-backed reserve currency, would actually benefit international trade.

Floating exchange rates and free trade, the fundamentalists argued, would stimulate trade flows. Any extra cost to traders of having to insure against currency fluctuations would be more than compensated by the increased trade flows. And, being constantly valued by the market, all currencies would be readily tradable.

It was further maintained that no exporter could keep a permanent export advantage. As any one country's exports expanded, so the value of its currency would increase. Accordingly, its future exports would become more expensive and less competitive. Other exporters with a less valuable currency would enjoy a price advantage which would translate into an increased export market share. Thus, floating exchange rates would steer the system towards lasting equilibrium.

Maintaining this equilibrium depended absolutely on exporting countries permitting their currencies to increase in value as their exports increased. What none of the fundamentalists anticipated or acknowledged was the fact that some exporting countries could, and would, corrupt the system. They could, by holding down the value of their currency, retain - more or less permanently - an export advantage.

Germany, and then Japan and China, in turn, did just that. The other Asian exporters followed. Thus, the equilibrium which floating exchange rates were supposed to maintain was gradually destroyed.

The major exporters, by holding down the value of their currencies, became - and continue to be - permanent savers. They built up enormous currency reserves based on export income. Lucrative, consumer-based Western markets were their target - notably those of the US and Britain.

Under the combined influence of market deregulation and free trade, US and British consumers, tempted by the opportunity to buy cheap imports, borrowed beyond their means. The saving economies' burgeoning surpluses provided the funds which enabled US, British and European financial institutions to underwrite excessive consumer debt, especially in the US and Britain.

Once levels of consumer debt passed saturation point, the entire edifice collapsed. Consumers could no longer afford what they had bought, let alone buy more. Financial structures in the US and Europe, created to finance the spending sprees, collapsed, and so did consumer spending.

What began as a financial crisis quickly turned into a full-scale economic crisis. The world tumbled into recession.

For the moment, nobody can do more than guess how long the recovery process might take or quite what the future world economy might look like.

But, almost certainly, nothing can be made right while the chronically-unbalanced trading system remains. It has been the trigger for the financial crash.

In October 1929, the Wall Street stock market crash ushered in the 1930s Great Depression which spread across the world. Eighty years on, the present global financial crisis reminds us once again that world trade can only operate smoothly if it is tied to a reserve currency arrangement. Twice in the 20th centiry, a gold standard provided that kind of reserve.

In the past, that has been provided by some kind of gold standard managed by the dominant world power. In the same way, economic recovery will depend upon our finding some way of re-creating a reserve currency to back world trade.

Curbing imports

We are a long way from that. Meanwhile, pushed by necessity, the spending economies are taking matters into their own hands and curbing spending on imports.

China, Germany and Japan, along with the others, should not blind themselves to the fact that Britain and the US can't, and won't, spend themselves into bankruptcy to preserve the unreasonable export aspirations of the main saving economies.

The world desperately needs to agree on more considered corrective actions, if it is to avoid uncomfortably high levels of long-term unemployment, especially for the exporting countries.

- Colin Teese is a former deputy secretary of the Department of Trade.